The cost of capital of a project is the minimum required rate of return expected on funds committed to the project. It is the required rate of return by the providers of funds.
Significance of cost of capital
- It is useful in long term investment decisions so as to determine which project should be undertaken. The techniques used to make this decision include net present value and IRR.
- It is also used in capital structure decisions to determine the mix of various components in the capital structure. The cost of capital of each component is determined.
- Used for performance appraisal. A high cost of capital is an indicator of high risk attached to the firm usually attributed to the performance of the management of a firm
- In making lease or buy decisions. In lease or buy decisions the cost of debt is used as the discounting rate.
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